Is China’s decision last week to break the renminbi’s (RMB) quasi-peg to the U.S. dollar – and allow the currency to depreciate by 4.5% against the dollar in the space of a single week – good or bad news for the global economy and markets? This is what observers have been trying to decipher ever since the surprise announcement (for example, here is a comment from my colleague Marc Seidner on Friday). Here’s my clear and unambiguous answer: It depends!
If China were merely to embark on aggressive currency depreciation without further domestic monetary easing and market reforms, this should be seen as bad news. Chinese exporters would gain a competitive advantage at the expense of foreign exporters in global markets, and the world’s third-largest economy (behind the U.S. and EU) would pass the deflationary bug, which it partly imported by allowing its currency to appreciate significantly alongside the dollar, back to the rest of the world. Devaluing a currency with a stroke of a pen is a zero-sum game – what you win, others will lose.
If, by contrast, China’s currency regime change were part of a wider strategy of broad-based monetary easing and market-oriented reforms, and if other central banks were to ease or postpone tightening monetary policy further, China’s RMB move should be good news for the global economy and risk assets. As we see it, more domestic monetary easing by the People’s Bank of China – in the form of lower bank reserve requirements and a cut in lending and deposit rates – is likely in train. This would ease strained liquidity conditions, help to prop up the stock market as well as business and consumer confidence, and should take the currency lower still.
If so, many other central banks would likely respond either by cutting interest rates further, extending their current quantitative easing programs or postponing tightening. Even the Federal Reserve, which seemed determined to embark on a shallow tightening path as early as September, may have second thoughts now that the broad trade-weighted dollar has climbed to a new high and oil prices and market-based measures of inflation expectations have declined further.
Make no mistake: China’s currency move matters a lot. And central banks’ responses will be crucial now in transforming it from zero-sum to win-win for the global economy and markets.